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Tuesday, April 30, 2013

Correctly defining the scope of financial regulation so as to block ponzi schemes

by Smriti Parsheera and Suyash Rai.

Attack of the ponzi schemes

The Saradha Group has gained notoriety in recent weeks with outstanding public deposits reportedly exceeding Rs.200 billion. There was anger and panic. The state government has stepped in with partial redress.

As we watch this saga unfold, there may be another crisis waiting to happen in the form of a pyramid scheme offered by `Mavrodi Mondial Moneybox (MMM)' that is taking rural India by storm. MMM claims to be a `social financial network' in which members voluntarily share money with each other by buying and selling MAVROS - a currency-like unit devised by the operators of the scheme. MMM claims to generate returns of over 40% per month, although the returns are not guaranteed. It may be a ponzi scheme: one where money collected from new investors is used to pay returns to old investors. The cycle will continue till inflows into the scheme exceed outflows.

Saradha and MMM are not isolated examples. Other recent schemes have involved promises of unrealistic returns from investments in goats, pigs, emu, teak wood and potatoes.

The history of savings and investments in India is replete with tragedies where financial firms fail to return deposits or investments. This is particularly problematic in a country where 70% of the people earn under 2 dollars a day and hence have small amounts of money saved up. If savings are not safe, the central objective of regulation - consumer protection - is not met. What we need is for institutions that take deposits or run investment schemes to operate in a safe and sound manner, within the bounds of financial regulation.


Under the present system there are many institutions that offer deposit or investment services without any form of approval or regulation. Under a fragmented regulatory system, hazy lines of work have been drawn between financial regulators, the Central Government and State Governments. This has led to the problem of under policing - anything that does not fall squarely within the lines tends to pass unnoticed from under the radar of regulation. Saradha presents a good example - its activities could be argued to fall under any of the following categories: running a collective investment scheme (regulated by SEBI); running a chit fund (regulated by the state government); a private company taking deposits for its business (regulated by the Registrar of Companies); and taking public deposits as a non-banking financial company (regulated by RBI). The Saradha Group chose to seek permission from none of these.

There is also inconsistency in the manner and extent of regulation of financial institutions performing similar activities. For instance, 265 non-banking financial companies and 18 housing finance companies are allowed to take public deposits, but they don't enjoy the same deposit insurance protection that is available to banks. If the main rationale for deposit insurance is to protect depositors from the risk of a financial institution becoming unable to make good on its promise to refund public deposits, should the same logic not apply to all deposit takers?

Chit funds, which are governed by State governments, also suffer from the problem of inconsistent treatment. Differences in enforcement levels across States have resulted in some States becoming more prone to ponzi schemes. In addition, most this sector may be operating in the form of unregistered chit funds: it is estimated that registered chit funds have collected Rs.300 billion worth of deposits while the collection of unregistered funds is much higher at Rs.30 trillion.

The regulation of collective investment schemes that come under SEBI's scanner has also left much to be desired. This is largely on account of the restrictive mandate. Section 11AA of the SEBI Act defines "collective investment schemes" in terms of principles to identify such schemes, but it contains exemptions for institutions such as chit funds, nidhis and cooperative societies. Pointing to the huge investment grey market that plagues the financial sector, the SEBI chairman U. K. Sinha observed that the loopholes in the existing laws are the primary cause for the situation. He pointed out the need for a single regulatory body to look into the regulation of all companies that take illegal deposits from the public.

Eliminating the threat of ponzi schemes: The sound answer

The draft Indian Financial Code (IFC) framed by the Financial Sector Legislative Reforms Commission (FSLRC) presents a comprehensive solution to address the problems of under-regulation. The FSLRC has recommended a clearer and more comprehensive regulatory architecture as compared to what we currently have - RBI would regulate banking and payments, and a Unified Financial Authority (UFA) would cover all other financial services and products. Within this structure, there would be no scope for confusion about who should regulate a Saradha or MMM India as this responsibility would clearly vest with the UFA. This will also bring about more consistency in the regulatory treatment of a range of institutions undertaking similar activities, irrespective of the institution-type.

A central law like the IFC cannot address the problem of dual regulation of cooperative banks, which are regulated by the state governments and the RBI. The FSLRC has recommended that state governments accept the authority of Parliament (under Article 252 of the Constitution) to legislate on regulation and supervision of co-operatives carrying on financial services. Once they do that, financial regulation can fully apply to these institutions.

Defining financial products and services

In the IFC, the definitions of financial products and services are broad and principles-based, with no statutory exemptions. All kinds of deposit-taking and investment schemes (including chit funds) are covered by these definitions. A deposit is defined as a contribution of money, made other than for the purpose of acquiring a security, which may be repayable at the demand of the contributor. In Section 2(90), an investment scheme means:

any arrangement with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangement, whether by becoming owners of the property or any part of it or otherwise, to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income, where:
  • persons participating in such schemes do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions; and
  • the arrangement has either or both of the following characteristics:
    • the contributions of the participants and the profits or income out of which payments are to be made to them are pooled; or
    • the property is managed as a whole by or on behalf of the operator of the scheme.

Anyone in the business of accepting deposits or managing investment schemes would need to get authorisation from the UFA. Accordingly, both Saradha and MMM would be covered under the IFC, the former as a deposit-taking firm, and the latter as an investment scheme. In case of the MMM scheme, a unit of MAVRO is the underlying property in which the members invest. The other tests of the definition are also met as the scheme members do not have the ability to control the unit, which is managed by the operators of the scheme.

The IFC also empowers the central government to expand the definitions of financial products and services. When a new financial product or service is observed, instead of waiting for an amendment to the law, the Central Government can include the new product or service in the definition.


Given the limitations of existing financial institutions in meeting the savings and investment appetite of all Indians, innovations in this field are both inevitable and necessary. However, to ensure that this does not happen at the cost of consumer interests, the scope of formal financial regulation needs to be expanded to include large segments of the currently excluded investment grey markets. This also requires us to move away from the present system of having regulatory responsibilities divided among financial regulators and State Governments. The FSLRC's draft law offers a viable solution in terms of conferring the duty of regulating all investment schemes on a single regulatory body that will be fully accountable for this task. The complete, principles-based framework of definitions, that can adapt over the years, will also help minimise regulatory gaps.

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